4 Lessons from Top Fund Managers

08/10/2012 8:15 am EST

Focus: FUNDS

Ari Charney

Analyst and Associate Editor, Canadian Edge and Personal Finance

You can read and listen to all the theory you want, but following what top fund managers do to stay profitable and reduce risk is cutting to the chase of successful investing, writes Ari Charney of Investing Daily.

After almost a year of interviewing top portfolio managers for Benjamin Shepherd’s Wall Street, I realized that some of these conversations had yielded key investing insights that should be gathered in one place. While much of their investment process involves painstaking fundamental analysis, their approach to risk mitigation is probably the most salient takeaway for the average investor.

Interestingly, many of the fund managers who post market-beating returns while incurring less risk aren’t necessarily mindful of risk reduction when they’re constructing their portfolios. Instead, this characteristic is merely a byproduct of their security selection.

So what kinds of stocks perform well while incurring less volatility than their peers? Well, the underlying business must have a shrewd management team whose interests are firmly aligned with long-term shareholders.

Is Corporate Management Shareholder-Friendly?
Nearly every fund manager cites the importance of vetting a company’s management. But while they might be able to fly at a moment’s notice to interview a management team at company headquarters, that kind of access isn’t happening for the retail investor.

Fortunately, most fund managers say their assessment of management’s prowess is based on two key factors: 1) their skill at capital allocation, particularly when it comes to cash flow; and 2) high levels of inside ownership.

Like most investors, fund managers welcome price appreciation, but they know that over the long term, such gains won’t be made with a management team that destroys shareholder value through empire-building acquisition sprees, excess leverage, or buying back shares at market peaks.

A company’s executives have several options for how they deploy their cash flow. They can use that cash for share repurchases, dividend payouts, reinvestment in growth, paring debt, or pursuing acquisitions.

Dividends Impose Fiscal Discipline on Companies
As shareholders, fund managers like to get paid first, and that means finding a company that’s dedicated to paying a dividend and growing its payout over time. But they don’t want to see a dividend that’s so high that it impairs a company’s ability to internally finance its growth with the balance of its cash flow.

Depending on the company, David Ruff, who manages Forward International Dividend (FFINX) and Forward Select EM Dividend (FSLRX), tends to look for companies with dividend payout ratios between 30% and 60%.

From a cynical perspective, the discipline of maintaining a dividend helps constrain management’s ability to waste capital by simply leaving them with less cash to do so. However, most fund managers want to see what choices a company is making with its cash flow based upon the operating environment, as well as what’s happening in both its sector and the broad market.

Each of the five aforementioned uses of cash flow can be valid depending upon the prevailing circumstances, so management’s judgment and timing are key for such decision making.

Having “skin in the game” is also a major management incentive. A company whose management has high levels of inside ownership is less likely to be concerned with beating the Street on a short-term basis, and far more likely to be focused on creating long-term growth for shareholders. After all, as major shareholders themselves, they probably stand to benefit the most from the success of their strategic vision.

Buy Stocks With a Margin of Safety
Valuation is also a key part of risk-mitigation. After fund managers decide what they’re willing to pay for a company, they may wait years until its share price accommodates them. But the market isn’t always a particularly welcoming place when stocks go on sale.

At the trough of the Great Recession, for example, Steve Scruggs, portfolio manager of Queens Road Small Cap Value (QRSVX) recalled that he personally felt the financial system was unraveling. But he had a longstanding methodology and adhered to it despite his very human anxiety about the macro picture.

Numerous stocks were trading at levels well below his estimates of fair value, so Scruggs took his portfolio to fully invested, which turned out to be an extremely timely and profitable decision.

Conversely, Scruggs is more than willing to let a portion of his portfolio idle in cash when the market gets ahead of itself. Of course, his approach to his fund’s cash position is less conventional than his industry peers. While his fund’s cash level was roughly 22% when I chatted with him a few months ago, most portfolio managers rarely let their cash levels grow beyond the mid-single digits.

Asset Allocation and Rebalancing Are Key
Instead, other fund managers, such as Charles Severson of Baird MidCap (BMDSX), focus on portfolio construction through proper position sizing and sector weighting to help reduce risk.

Although his fund may be almost fully invested at all times, that hardly means it’s a static portfolio. Instead, Severson trims positions as they approach or exceed their valuations, and reinvests the proceeds in existing undervalued positions. In fact, Severson says that roughly 40% of his portfolio’s annual turnover occurs from this process.

Similarly, he adjusts his sector weightings based on the macro picture. During a bull market, he’ll lean heavily on outperforming sectors, while during bear markets he’ll dial back sector exposures to levels commensurate with his benchmark.

Severson’s efforts are not entirely dissimilar to the rebalancing that most investors perform with their portfolios once or twice a year. But instead of a purely mechanical and infrequent process, he’s making these changes by examining his portfolio at a granular level on an ongoing basis.

Although individual investors may not have the time or resources to analyze their investments like a true portfolio manager, they can at least reduce the risk in their portfolios by paying attention to the aforementioned fundamental characteristics, being disciplined about what they’re willing to pay for a stock, and adjusting stock and sector exposures when things get too frothy.

Read more from Investing Daily here...

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